Re:Balance -- Jim Peterson

Disintegration of the Big Four -- Where is the Tipping Point Today?

Time for an update: how large is the litigation hit that would devastate one of the Big Four accounting firms?

The answer is a number that is shockingly small, in light of the large firms’ aggregate estimated litigation exposure of up to $140 billion and their individual confrontation of multiple claims ranging up to and well above $10 billion.

But it cannot be avoided. Reckonings are coming, when the debate on the survivability of privately provided audit services is revived – which will be some time after the U.S. elections and the dust-settling around the world’s banking bail-outs.

Quantification of the impact that would trigger the disintegration of the global networks -- leaving the world’s large companies unable to procure the audit reports necessary for listing and regulatory compliance – was a subject last visited two years ago.

A study done in September 2006 for European Union markets commissioner Charlie McCreevy (here) did that calculation for the large U.K. firms. I applied its model to the Big Four’s American firms that December (re-published here) – and attracted no substantive disagreement, but instead grudging if off-the-record concurrence from those positioned to know.

A revision is now possible, and the news is no less grave.

The recent report of the U.S. Treasury’s Advisory Committee on the Audit Profession (here), for all its insipid unwillingness either to acknowledge the gravity of the audit survival risk or to propose an achievable course of action toward real solutions, did provide updated financial data from the large firms.

Those figures can be run through the prior model, after a quick recap of its basic assumptions: 

•    Not having access to outside investors, under regulatory limitations, and impelled by tax laws to distribute their profits, the accounting firms operate on the thin but vital base of their partners’ personally invested capital.

•    The insurance industry’s readiness to contribute to the firms’ litigation outcomes is insignificant compared to the size of pending claims; comes – if at all – only on top of large and growing deductions and retentions; and in any event takes primarily the form of time-shifting finance.

•    As a result, large litigation settlements must be funded out of future partner profits, which depend on the ability of the firms to retain both clients and personnel.

The original London study assumed that, in a highly-charged crisis environment dominated by the pressure and publicity of a massive adverse litigation result, critical numbers of partners would defect, so as to put a firm into a death spiral, if faced with a profit reduction of from 15 to 20 percent and extending over three or four years.

Based on the profits calculable on the Big Four firm’s U.S. revenues of between $5.3 and $9.8 billion, as provided to the Treasury Committee, the bust-up figures would be as small as $560 million, up to just over $2 billion. (Those wanting a walk through the model are invited to write me.)

Could such death-blow amounts be inflicted? On top of the firms’ recent hefty payments to settle many (but not all) of the wave of post-Enron litigations, the outstanding jury verdict of $521 million against the Seidman firm in Florida (see here) starkly demonstrates the possibility. And the obligation of plaintiffs’ lawyers to represent their clients’ antagonistic interests weighs against any lingering unwillingness they would have to kill the gaggle of golden geese.

Would the Big Four firms’ international networks step up? Although by all measures the most cohesive and financially robust of the firms, Arthur Andersen collapsed in 2002 with a speed that suggests otherwise: that firm’s ability to call on either foreign resources or partner commitment proved ephemeral.

Keep in mind that loss of another Big Four firm will throw the entire system into chaos – for lack of auditor choice and readiness among the survivors to stay in an untenable business. So the stability of the entire fragile structure includes the continuing survival of the weakest of them. 

That in turn exposes the hopeless state of the public debate. When corporate bankruptcies have shot far beyond the $100 billion mark, it’s a dead certainty that investor advocates can kill at birth any proposal to limit auditor liability at a level low enough to include the tipping points.

Nothing less is required, then, to enable the survival of large-company audits under the current model, than a de-coupling of the machinery of investor protection and auditor oversight and enforcement from the Big Four firms’ fragile capital structures.

Until that point is recognized and on the table – even if not agreed—the debate goes nowhere. While the risk of catastrophic failure only grows.

Thanks for joining this dialog; your comments are welcome, and if not a subscriber, you are invited to sign on at the Home page – easy, free and non-commercial.     

  

"Where were the Auditors?" In this Crisis, Nobody Asks - Because Nobody Cares

In the rural America of my youth, the ultimate symbol for feckless optimism was the farm boy discovered in the barn early on Christmas morning, digging in the manure pile, crying out that, “With all this horse-shit around, there must be a pony under here somewhere.”

My series of meetings last week started with the investment officer of a large hedge fund. Over an extremely dour martini he volunteered his list of those responsible for the nightmares still spreading from the credit markets through the entire world economy:

•    Homebuyers whose aspirations overreached their ability to pay.
•    Mortgage lenders piling up immediate fees for unsustainably aggressive products with neither rational underwriting nor retained risk.
•    Bankers made rich beyond reason by packaging subprime mortgages and other exotic products into slices too complex and obscure to be comprehensible.
•    Ratings agencies whose imprimatur was the key to worldwide distribution of these previously unknown instruments.
•    Investors so graspingly eager that they bought uncritically into the triplet myths of a never-ending real estate boom, ring-fenced exposures and fail-safe yields.
•    And the regulators and politicians whose laisser-faire enabled the entire fiasco.

I waited for him to include the auditors – scapegoats inevitably tagged for blame in every scandal’s aftermath. And waited.

And was still waiting, later that day, when my other friend the insurance executive laid out the precisely identical cast of miscreants  -- with the same unexpected omission.    

In this non-scientific sample, despite the raging furor over accounting standards for fair value and the world-wide lobbying for relief from mark-to-market requirements, nobody was pressing the question, “Where were the auditors?”

There will be days of reckoning to be sure: the Big Four all face new mega-claims -- gratuitous to recite, because taken from the familiar roster of failed financial institutions.

But instead of hauling the auditors into their hearing rooms, the grand-standing politicians are making sport with such fallen executives as Richard Fuld of Lehman and Martin Sullivan and Robert Willumstad of AIG.

My two highly knowledgeable friends both distinguish earlier waves of corporate malfeasance: In this era of turmoil so extensive and widely supported, the accountants didn’t cause the problems in the first place, and in the second, they’re not important or influential enough to provide a fix. 

The value to users of large-company audits began to deflate in earnest in the 1980’s, during the piratical recapitalization of corporate America led by the likes of Ivan Boesky, Michael Milken and Henry Kravis. An unobserved non-event back then, when the predators would lose a deal and lick their wounds and go on to the next deal, was the total absence of claims against auditors.

The simple reason was that no disappointed raider could be bothered to assert reliance on audited financial statements – no such claim would have been credible, when those reports attracted only yawns in the due diligence rooms before being tossed aside.

The trend continued at century’s turn, during the dot-com boom, when stock prices became completely unhinged from traditional financial reporting – when price/earnings ratios were irrelevant to IPO’s and hot after-markets, because flotations did not even require revenues, much less the rigor of real earnings.   

And today, unbidden, the accountants are unheard in the public debates on the causes, accountability and solutions for the credit market debacle. Even on fair value, their predictably rational and sensible position (here) puts them, as customary, on the opposite and futile political side from the forces of influence – unable to stop or even deflect the overwhelming rush to satisfy the world’s bankers specially pleading for the authority to “mark-to-fantasy”.

There are ominous long-term implications in the accountants’ slide to marginalization. Balance sheets loaded with toxic assets that are “marked-to-whatever” will suffer for credibility under the noses of skeptical investors, who know full well that the pile of manure is still fermenting somewhere.

In the same way, the fundamental issue of trustworthiness – on which the entire value of the auditors’ franchise perilously rests – is put under scrutiny when they are effectively sidelined for want of influence and capacity to persuade.

Which marks a shift in the debate on the continuing viability of the profession’s future. Whether the Big Four are “too big to fail” or “too fragile to survive,” it increasingly appears that – if the auditors are so insignificant that they are being ignored, even to be criticized -- then they are “too irrelevant to matter.”

Sad as it is, that bodes ill.

Thanks for joining this dialog. Reader comments are welcome; those not already subscribers are invited to sign on at the Home page – easy, free and non-commercial.     

If the Banks are Nationalized -- Why not the Auditors?

I’ve been in a lively exchange with Francine McKenna (Re: The Auditors) – she of the stiletto heels and equally sharp tongue – especially about her tart message last week to Senate banking committee chairman Christopher Dodd (D-Conn.):

“Demand PwC be fired as AIG’s auditors, and get rid of Fannie Mae and Freddie Mac auditors (Deloitte and PWC, respectively). Have the PCAOB audit them directly.”

Take Francine’s position (elaborated here) for discussion, without necessarily agreeing, that the Big Four should be stripped of their engagements for the large financial institutions subject to government rescue or take-over. At the heart of the concern: with all the Big Four carrying death-penalty litigation into the current mess, and all being targets of new mega-claims, there are no available private alternatives.

Her interesting view is that with Fannie and Freddie taken over – and with the government’s controlling interest in AIG and about to invest in nine of the country’s largest banks -- its interests and those of taxpayers are best looked after by a government-run audit function as well.

Expand the PCAOB’s current remit, she says, or create a new form of inspector general.

Despite a skeptical first reaction, this may be the plausible path to the re-engineering of the model of private assurance -- which I’ve been arguing (for example, here) is inevitable with a litigation-driven collapse of the Big Four themselves.

Here’s why:

First, Francine sees no problem in building a federal audit agency. Currently the PCAOB has 500 staff. To build a remotely credible capability, it would have to grow by orders of magnitude, at all experience levels and in world-wide locations. But personnel will be available: The wave of bank failures, bail-outs and mergers is drastically reducing the population of surviving institutions, so the net loss of clients among the Big Four is about to put small armies of bean-counters on the streets.

While it is depressing to think of the creation of yet another vast bureaucracy, the civil service manpower needed through the years of the trillion-dollar bailout reduces opposition to a quibble. It does require noting, however, that the hiring will be of those unable to migrate their stature and compensation in the private sector – namely, the superannuated and the second-rate – not exactly a recipe for staying ahead of a sector of mind-bending complexity.

It bears asking, also, how the concepts of independence and avoidance of conflicts could be squared with the appearance of one agency auditing another. But since the intellectually sound argument for “independence in fact” gave way decades ago with the rationalized acceptability of “client pays,” it would be an easy step to condone a cross-Washington audit function.

As for the questionable value in the market place of an report both by and for the government, the current one-page “pass-fail” audit report is already a no-value anachronism (see here), useful only for statutory compliance but of no useful purpose to investors. So it could as well be done by a collection of civil servants, with the diminished level of attention and respect it would deserve.

Government assumption of audit responsibility opens this tempting door:

Even under state ownership, the huge and complex financial institutions will have undiminished future needs for sophisticated and specialized assurance – in such areas as financial product design and evaluation, process execution and operational soundness – which the Big Four should be both able and enthusiastic to design and deliver.

Freed from delivery of low-value but litigation-laden audits, they should in reason be evolving their services -- only under contractual terms unburdened by the threat of investor claims.

To be sure, for the sake of transparency and accountability of public funds, the banks themselves might well choose to offer to the outside world the reports they would obtain from the Big Four (or the niche providers who would no doubt arise by spin-off or new growth) – but this would be under strict limitations of warranty and liability. 

Tasting both the potential stream of new revenue and the liability relief offered under such a model could be heady for the Big Four, who might well see the potential to extend the model across the entire spectrum of public companies.

In practice, they could tender to a new audit agency the keys to their now-outmoded franchise – thereby finally unshackling themselves from its unsustainable burden. By evolving into sources of real user value, they would escape the looming fate of catastrophic collapse.

Senator Dodd has not given Francine the courtesy of a response – which seems a little ungracious, for a politician savvy enough about the new media to run his own blog and subscribe to an instant message platform.

Especially when she has lit the fuse on an issue ripe for political leadership. By taking up this opportunity, under Dodd’s sponsorship, the large firms could be enabled to survive --- to re-design their assurance products, to re-discover relationships with their clients, and to restore their purpose. 

Thanks to readers for joining this dialog; your comments are welcome, and if not a subscriber you are invited to sign on at the Home page – easy, free and non-commercial.

Congress Looks at the Fall of Lehman Brothers: Was it a Sequel to Arthur Andersen?

For low-grade political theater, Monday in Washington was sadly typical: Richard Fuld, ex-CEO of the bankrupt Lehman Brothers, spent two hours under ritual excoriation by a panel of self-righteous legislators.

The play ran in several predictable acts:

•    The outlandish and unseemly “fairness” of Fuld’s nine-figure compensation history, in context of the firm’s disintegration and the erasure of equity value for public shareholders and trapped employees alike.
•    The absence of timely leadership responsibility and Fuld’s finger-pointing at exterior forces -- the rumor-mongers and the short sellers.
•    The whining over Lehman’s solitary fate, while the government supported “rescues” – if such they can be called – of such fallen institutions as Bear Stearns, Fannie Mae, Merrill Lynch and AIG.

Melodramatic scenes of tearfully innocent ex-employees hauling off boxes of personal effects and the pathetic invocation of antagonistic government treatment invite comparison of Lehman’s downfall with Arthur Andersen’s speedy demise in 2002.

They’re equally unfortunate, especially in the personal and systemic disruptions caused by the disintegration of once-noble institutions, but neither fits well the classic model of tragic definition.

Just as with the failure of Fuld’s leadership to admit the mounting evidence of compelling weakness in Lehman’s business model, the belated calls for stabilizing steps at Andersen came too late to escape its death spiral of departing personnel, fleeing clients and global structural break-up.

Likewise, Fuld’s invocation of the influence of darker forces corresponds with the self-inflicted aspects of Andersen’s demise, despite the clinging among members of Andersen’s alumni and sympathizers to a sinister plot line driven by vengeful prosecutors.

That is, while Fuld is chargeable with denial and delayed recognition of reality and a lack of credibility in his case for last-minute rescue, Andersen was reportedly perceived by the government prosecutors as a firm of arrogant and unrepentant recidivists and repeat offenders – not a tactful attitude conducive to amiable treatment by agents holding the power of indictment.

Finally, while the enterprise value of Lehman and Andersen alike rested critically on the continued repose of trust and confidence by both clients and personnel alike, neither management saw on a timely basis the fraying of the fragile fabric of reputation which -- once torn -- was damaged beyond repair.

The Lehman / Andersen comparison should not be pushed too far – Lehman became its own house of cards, for one thing, while Enron as a business fiction served that role for Andersen.

More to the point are differences as to the treatment of successor institutions. Last week’s US bail-out legislation and the programs emerging daily from other governments around the world amply demonstrate that “too big to fail” has broad resonance for the world’s trading and financial systems – for the benefit of troubled enterprises trailing in the wreckage of Lehman.

But for the surviving large accounting firms, confidence in their assured future viability remains a goal that has eluded the limits of their political and lobbying skills.

And in any event, the break-up and migration of the bankers’ brands, corporate structures and business teams – whether Lehman or any of the others – has no correspondence in the ability to preserve the Big Four’s private partnership organizations or their requirement for global presence to serve their large-company clients. 

Richard Fuld may be the least appealing villain of that name since Shakespeare’s king – who at his end at least had the consistency of character to go down in battle, crying, “My kingdom for a horse!” rather than “I’ll keep my millions – now where was my bail-out?”

But he was not redeemed either by the windy pontifications of the likes of Congressmen Henry Waxman or Dennis Kucinich – whose own troubled constituents might well have watched Monday’s posturings while wondering about their public guardians soundly asleep at the switches.

Meanwhile, the fates of both Lehman and Andersen make clear that vitality based on trust and loyalty will not survive the evaporation of either – in which case, it’s curtains.

Special thanks on this one for the advice and support of Charlie Green – whose general wisdom on these matters is at Trust Matters.

Thanks to readers for joining this dialog; your comments are welcome, and if not a subscriber you are invited to sign on at the Home page – easy, free and non-commercial.

Don't Like "Mark to Market"? How About "Mark to Congress"?

With the chaos in Washington over legislation to bail out Wall Street, looking like nothing so much as the stateroom scene in the Marx Brothers’ “Night at the Opera,” it’s remarkable that only now have the poor accountants shown up.

Should politicians be entrusted to write accounting standards? With the Securities and Exchange Commission already leading the way – here -- relief is proposed of the obligation to “mark to market” the toxic waste on institutional balance sheets – the accumulated tranches of subprime mortgages, credit default swaps and other creative derivatives now freezing up the financial markets. 

The idea is that the otherwise imminently sensible Statement 157 of the Financial Accounting Standards Board – and its cognates in Europe, if French President Nicholas Sarkosy and UK Conservative leader David Cameron have their way – would be eased to allow companies to apply their own judgment – such as it may be – in valuing financial holdings that nobody understood or could properly value from the time they were invented and launched into the stream of commerce in the first place.

And why not? The injection of politics into accounting rules has a long and sorry history – from the technology industry’s perfervid opposition to expensing stock options, to Enron’s lobbying for permissive rules on special purpose entities, to the French-led revolt of European banks against the use of “mark to market” rules for derivatives.

So should Congress be trusted to meddle with the intricacies of financial instruments valuation -- in the same way that they railroaded the Sarbanes/Oxley law in the summer of 2002? What they accomplished then, in an exercise in unintended consequences, was to inflict immense cost and disruption on corporate governance, poison the relationships between issuers and auditors, and entrench a bureaucracy at the PCAOB whose principal achievement is its own perpetuation, while – as today's turmoil makes clear -- conspicuously failing to instill corporate virtue by either fiat or paperwork.

Can it be sensible to relieve the holders of locked-up financial instruments of the obligation to confront the reality of their distressed values – when the wreckage extending from Bear Stearns through Merrill and AIG to Washington Mutual and Wachovia is eloquent testimony that the bankers were and remain clueless as to legitimate and reliable valuations? To do so is to perpetuate an environment instinct with hazard, to reduce the already doubtful quality of financial information available to investors, and to foist off to the future the ultimate reckoning in further barrels of red ink.

The rationale that “mark to market” need not be applied so long as the mysterious paper will be held to either maturity or at least a restored and active market suffers two reality checks:

First, this year’s cascade of institutional failures makes questionable any assumption that a particular holder will survive long enough to see its portfolio restored. And second, with the depths of the American recession still unmeasured both in real estate and across the spectrum of household consumption, there is no currently realistic estimate of the ultimate write-offs still to be taken.

All else aside, it’s likely not to work. How can trust and confidence be restored, when financial statement readers will sniff out the bags of garbage still rotting on the balance sheets – whatever their new names or mythified valuations? Reducing rigor and transparency in the name of management judgment leaves the keys to the henhouse in the hands of the foxes.

There is one glaring irony in the “mark to market” discussion – namely the late-arriving opposition of the large accounting firms themselves to the easing of the rules – here. As usual their position is rationally argued and intellectually sound – and as appears usual, they appear to lack both friends and influence.

The accountants have been demonized in the post-Enron era, and have failed to secure relief against the looming risk of catastrophic collapse of their franchise to audit large global companies.

But what they have not grasped is that a shift of accounting standards under the sanction of the Congress amounts to a “Get Out of Jail Free” card – a transfer of responsibility they could never achieve on their own.

For decades the accountants have been pilloried for their accommodation to their clients, in the courts and in the halls of the legislators. A suspension by law-makers of the “mark to market” requirements can no more relieve the consequences of past financial excesses than an attempted repeal of the law of gravity would enable pigs to fly.

But it would allow the accounting firms at last to hand back to the politicians the consequences of their folly.   

Thanks for sharing in this dialog. Please share with your friends and colleagues -- write with your comments -- and if not a subscriber, you may with ease sign up at the Home page.